Introduction to Corporate Finance

PArT 1: INTrODuCTION

The price/earnings (P/E) ratio measures the amount investors are willing to pay for each dollar of

the company’s earnings. Investors often use the P/E ratio, the most widely quoted market ratio, as a

barometer of a company’s long-term growth prospects and of investor confidence in the company’s future

performance. A high P/E ratio indicates investors’ belief that a company will achieve rapid earnings

growth in the future; hence, companies with high P/E ratios are referred to as growth stocks or shares.

Simply stated, investors who believe that future earnings are going to be higher than current earnings are

willing to pay a lot for today’s earnings, and vice-versa.

Using the per-share price of $76.25 for Global Petroleum Corporation on 30 June 2016, and its 2016

EPS of $5.29, the P/E ratio at year-end 2016 is:

Price/earnings(P/E)ratio

Marketpricepershareofordinary shares

Earningspershare

$76.25

$5.29

14.4 1

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This figure indicates that investors were paying $14.41 for each dollar of GPC’s earnings. GPC’s

price/earnings ratio one year before (on 30 June 2015) had been almost twice as high, at 28.37 ($71.50

per share share price ÷ $2.52 earnings per share).

The market/book (M/B) ratio provides another assessment of how investors view the company’s

performance. It relates the market value of the company’s shares to their book value. The shares of

companies that investors expect to perform well in the future – improving profits, growing market

share, launching successful products and so forth – typically sell at higher M/B ratios than the shares of

companies with less attractive prospects. Companies that investors expect to earn high returns relative

to their risk typically sell at higher M/B multiples than those expected to earn low returns relative to risk.

To calculate the M/B ratio for GPC in 2016, we first need to find its book value per share of ordinary

shares:

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Bookvalueper share

Ordinary shares

Number ofsharesofordinary sharesoutstanding

$4,278

178. 7

$23.94

We then compute the M/B ratio by dividing the book value into the current price of the company’s

ordinary shares:

Market/book(M/B)ratio

Marketvaluepershareofordinary shares

Bookvalueper shareofordinaryshares

$76.25

$23.9 4

3.19

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Investors are currently paying $3.19 for each $1.00 of book value of GPC’s shares. Clearly, investors

expect GPC to continue to grow in the future: they are willing to pay more than book value for the

company’s shares.

price/earnings (P/E) ratio
A measure of a company’s
long-term growth prospects
that represents the amount
investors are willing to pay
for each dollar of a company’s
earnings

market/book (M/B) ratio

A measure used to assess a

company’s future performance

by relating its market value

per share to its book value

per share